Standard Expected Utility Theory and Prospect Theory - Essay Example

Running Header: Standard Expected Utility Theory and Prospect Theory Student’s Name: Instructor’s Name: Course Name & Code: Date of Submission: Standard Expected Utility Theory and Prospect Theory Introduction Every organisation makes strategic choices in order to achieve goals. Strategic choice reflects a situation where top managers hold some discretion and chose actions that support various resources put into the organisation in order to employ environmental opportunities and maintain the values that managers prefer. Firms perform according to their top managers decisions1. This has raised various ideas where researchers investigate whether strategic decisions of managers affect the performance of a business and to analyse the outcome we shall used the most effective model that is the expected utility theory. This study compares and contrasts the standard expected utility theory and prospect theory of business management. It is suggested that top managers do not act according to the assumptions of the expected utility theory but instead equate probabilities of outcomes. This shows that managers rarely follow the principles of the decision theory. Decision biases has been one selective perception that affect the way managers obtain, process and assess necessary information used in decision making process. Decision biases shows that top managers make decisions basing on the most consistent outcome or using a problem that is already known. The expected utility theory describes how decision makers behave and how they improve their focus on decision making for example through training on how to analyse statistics or education on properties affecting utility theory2. Prospect theory on the other hand will need prospects that favour the consequences caused by framing. Some of the methods used include improved feedback of information flow across the organisation and frame structuring. One major comparison between the utility theory and prospect theory is that both of them are used to describe choice behavior and methods used by top managers in solving strategic decision problems. The expected utility theory introduced by Von Neumann and Morgenstern in the year 1944 states that choices are constantly made by the use of weighing options for example one may either gain from a particular choice or lose. The theory also shows that these actions are weighed according to their probabilities. The theory is therefore viewed in three dimensions while making decisions that are usually made under certain conditions such as risk and uncertainty. One of these dimensions is the consistency of preferences for alternatives3. The other is the linearity used in transferring weighing outcomes to alternatives. Finally, the judgment made as a result of a fixed asset position. Prospect theory shows decisions made between various alternatives for example those tat involve risks and whose prospects are identified. The theory is explanatory and shows that real life decisions are more important than making the best choice. The prospect theory shows the process used by managers while coming up with a particular choice of business and how profits and losses are evaluated in a business. This theory shows that while choosing the best alternative, two stages are used which involve editing process and the evaluation process. The editing process involves possible outcomes where a reference point is set that determines whether the decision is to bring a loss or a gain. Lower outcomes are said to be business losses while higher outcomes yield to profits. The evaluation process shows how a value or utility is worked out. This is achieved through analyzing potential outcomes according to probabilities then the one with a high level of utility is chosen as the best alternative. Daniel Kahneman and Amos Tversky introduced the prospect theory in the year 19794. The main reason for their introduction is to instill a psychological reality and an option to be used in place of expected utility theory. Kahneman and Tversky used assumed a formula to be used in the evaluation of utility where varying potential outcomes were given according to their respective probabilities. The value function is constant and is given an s-shape. From a reference point of view, the concave shape represents gains and it means a risk aversion. The convex shape represents losses that also show a risk-seeking situation. The diagram above shows a hypothetical value function used in prospect theory In contrast to the expected utility theory, the prospect theory is used to determine losses, gains, and not wealth. The formula used in measuring these losses and gains however has a weighing function which shows how people react in different situations. The meaning of this is that most people overreact while faced with small problems and under react in bad situations. The prospect theory is also used to express economic behaviours such as people’s characters or risk aversion reflected after a gain or a loss. It also explains the pseudo certainty effect that reflects the risk averse and risk acceptant cases5. This is applied in determining why one person may want to buy an insurance policy and at the same time purchase a lottery ticket since the theory related to gambling where one may either lose or gain. The prospect theory shows how economists come up with a transaction that affects the expected business utility6. The other implication of the theory as used by the economists shows that utility might be based on reference which is a contrast of the various utility functions for example as applied in the neo-classical theory. It also reflects that individuals consider sharing of utility. The implication of these two theories was that people put more focus on possible events that are likely to happen in future and underestimate certainty. However the prospect theory is not consistent with the expected utility theory. This is because of two major reasons; one is that utility function is usually linear in probabilities while the prospect theory that shows value function is not linear. The other reason is that utility depends on the final wealth to succeed while value depends on either gains or losses that are derived from the current wealth. The prospect theory is also concerned about how managers behave while faced with a situation where they have to choose one variable between two. This decision-making is based on risks and can be referred to as making a choice between gambles. The prospect theory has been of importance since it has brought about the concept of psychology into many economists. Recently, many economists have been utilizing the prospects theory as a substitute for the utility theory7. This is because they have realized that the prospect theory have a better approach of solving business issues. The prospect theory is based on mathematical calculation of events unlike the utility theory that contains much psychology. The other difference between the two theories is that the expected utility theory is concerned about how decisions should be made while the prospect theory shows hoe decisions are actually made. This means that the expected utility theory follows a prescriptive approach in decision-making process while the prospect theory uses a descriptive approach while making decisions. The creation of prospect theory was to formulate a cost -conscious theory that would fit well in many situations. The prospect theory therefore has more benefits as compared to the utility theory. This is because is shows that most people are illogical since they tend to gamble with their hard earned profits while they can do it with losses. This can be applied where people enjoy selling while earning profits and failing to sell in case of losses. The prospect theory has been applied in business where it helps managers to evaluate finance problems for example how investors are reluctant to sell goods of less value8. Investors also show risk aversion once they hold their stock speculating that the value of stock may rise in future. The theory shows how decisions are framed and the effect felt towards the outcome. The expected utility theory assumes that decision makers categorize their preferences first therefore showing that choice does not vary. It is however pointed out that in the decision making process, no method is perfect. Any method chosen has to have flaws and especially the utility theory. Conclusion Recent research about individual research and strategic decisions shows that most top managers have not been applying the assumptions as stipulated in the expected utility theory. This means that managers deal with some possible outcomes and tend to allocate probabilities to the outcomes that they already know. This indicates that top managers fail to follow the main principles of the decision theory but behave outside the concepts of the utility theory. These findings conclude that better decision-making models should be introduced to solve the problem of decision framing. This method of decision framing however, have various implications in that it deals with environmental issues, bargaining, resource allocation, risk and insurance. It is also concluded that managers decision making is influenced by a particular drive for example in case a problem occurs or an opportunity arise. The decision making process is also categorized into threats and opportunities which should be known before a decision is made. Bibliography Cornell, B. The equity risk premium, the long-run future of the stock market, Wiley, New York, 1999. Dawes, R. Everyday irrationality, How pseudo-scientists, lunatics, and the rest of us systematically fail to think rationally. West view Press, California, 2001. Shleifer, A. Inefficient markets, an introduction to behavioral finance. Oxford University Press, Oxford, 2000. Thaler, R. ‘Toward a positive theory of consumer choice’, Journal of Economic Behavior & Organization, Vol. 1, issue 1, 1980, pp. 39–60. Tvede, L. The psychology of finance. Norwegian University Press, Chichester, 1999. Tversky, A. & Daniel, K. ‘Advances in prospect theory, Cumulative representation of uncertainty’. 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